Managing Mortgage Product Development Risk
By MBA Insights Staff
September 19, 2017
The Mortgage Bankers Association's Research Institute for Housing America has released a new special report, Managing Mortgage Product Development Risk.
The paper (https://www.mba.org/news-research-and-resources/research-and-economics/research-institute-for-housing-america), authored by Clifford Rossi, Executive in Residence and Professor with the Robert H. Smith School of Business at the University of Maryland, recommends a more formalized approach to assessing mortgage product risk that takes into account both product and process risk.
"Mortgage banking is a highly cyclical business, prone to expansion and contraction as market conditions change," Rossi said. "Mortgage product innovation is healthy for the industry and consumer so long as product risks and process quality are well understood."
The paper noted intrinsic risks associated with mortgage products and processes amplified aggregate losses of mortgage originators, investors and servicers following the mortgage boom of 2004-2007. In many instances, product development acceded to market pressures as the economy expanded and regulatory oversight waned.
"Competition and a benign economic environment led to risk layering, where combinations of risky attributes significantly elevated strategic, market, credit, operational, reputational, legal and regulatory risk to firms," the paper said. "As products morphed over time in response to greater risk layering, it masked how these products would perform under stress and the impact of the manufacturing process quality to control risk."
Mortgage products represent combinations of borrower, loan, collateral and other risk factors that vary in terms of their impact on firm losses over time, the paper said. "As the crisis unfolded, the impact of mortgage product development went well beyond the traditional financial risks of credit, liquidity, market and interest rate risk," it noted. "Operational, reputational, regulatory, strategic and legal risks rose in prominence during this period. The mortgage process facilitated the increase in these nonfinancial risks."
Rossi said the potential for products to morph over time as features change in response to market conditions can lead to poor pricing, risk and business decisions. The paper, he said, provides the real estate finance industry with a framework for addressing both in an integrated manner.
"An empirical analysis of how product morphing translates into greater risk is conducted along with statistical analysis quantifying the relationship between process and credit risk," Rossi said. "I find that lenders with high repurchase rates (a proxy for process quality) relative to other lenders produced loans with statistically greater default risk, controlling for other borrower, macroeconomic, loan and collateral risk attributes. This process impact was particularly important during a period in which product risk increased from 2003-2008."
Rossi recommends development of a set of simple assessment tools that facilitate the effective development of mortgage products going forward.
"This focus is of heightened interest due to potential macroeconomic changes on the horizon, important demographic shifts that may require different products for nontraditional borrowers and even the possibility of industry expansion into non-QM mortgages," Rossi writes. "For example, there has been renewed interest in originating 99 and 100 percent LTV loans as well as mortgages with debt-to-income ratios up to 50 percent. Under such circumstances it is critical that lenders as well as investors and aggregators redouble their efforts to strengthen the processes used in the mortgage manufacturing process."
The paper describes scorecards for assessing product risk and process quality, leveraging systems engineering and commercial real estate risk rating methodologies. "Such tools can be customized and provide a means of evaluating mortgage products and for identifying potential gaps in processes and product prior to product release," the paper said."
The product scorecard takes into account risk layering, specific product features and target market factors in establishing a product risk score. Similarly, the process quality scorecard takes into account how various activities important to product development impact firm risk. A product development risk matrix is also presented, based on the final scores from both scorecards that can be used to determine whether a product should be implemented, revisions made to product and/or process before deployment, or rejected for implementation. "Such tools can be customized and provide a means of evaluating mortgage products and for identifying potential gaps in processes and product prior to product release," the paper said. "
Coupled with renewed interest by the Administration to reform aspects of the Dodd-Frank Act, the paper said such policies could bring on a period of growth that tests the effectiveness of existing mortgage product development processes.
The paper also noted household growth, along with an increase in the entry of millennial age borrowers to the housing market have been observed along with strong immigration growth in recent years. "These shifts in borrower demographics could lead to a variety of new products to support this demand," it said.
Without a structured approach, the paper said, mortgage product development can become overly influenced by short-term factors such as competitive pressures to match products to maintain market share, preferred sales arrangements or other strategies as markets expand. The financial crisis underscored the effects that poor product development had on the industry that eventually put many firms out of business.
"As products evolve and features change, analytics used to assess loan performance during product development become less accurate and the data used to model these outcomes less reliable as well," the paper said. "Moreover, product development must include an assessment of how important product features can lead to a range of risks that may ultimately result in higher losses to the firm."
"Now is a particularly important time to pay attention to risk management in mortgage products," said Lynn Fisher, RIHA Executive Director and MBA Vice President of Research and Economics. "The single-family mortgage market is undergoing significant change these days. As employment continues to improve and new construction eventually comes online, we will see increasing demand for new or re-imagined mortgage products."
Rossi said in an accompanying MBANow video (https://www.youtube.com/watch?v=6o9zT8qj_bo&feature=youtu.be) the motivation for the report has its roots going back to the financial crisis.
"We're about 10 years removed from the crisis and one of the things I learned in my time in the industry was that product development was something that was not well-evolved, generally speaking, across the industry," Rossi said. "So what I decided to do in this paper was to give those of us who were risk practitioners or even product development specialists better tools to be able to understand when the processes they have throughout the entire lifecycle of the mortgage process aren't good enough to handle the type of risk-taking that institutions want to take on they have tools now in place to be able to help them understand better what that risk looks like."
Rossi will discuss this paper and other emerging risk management issues during a panel at the MBA Risk Management, Quality Assurance & Fraud Prevention Forum 2017 in Miami, taking place Sept. 24-26. For more information, click https://www.mba.org/conferences-and-education/event-mini-sites/risk-management-qa-and-fraud-prevention-forum-2017.
The MBA Research Institute for Housing America is a 501(c)(3) trust fund. RIHA's chief purpose is to encourage and assist--through grants to distinguished scholars and subject matter experts, educational institutions, research facilities and government organizations--establishment of a broader based knowledge of mortgage banking and real estate finance. Additional studies are on the RIHA website, www.housingamerica.org.